Theories of the firm based on property rights have been the focus of much research in the economics of organization, both explicitly and implicitly. These theoretical interpretations of the firm are varied, however. The explicit concerns primarily examined in this literature are transactions costs, contractual relationships in general, and the principal–agent relationship in particular. These approaches to studying the firm focus on specific important questions within the theory of the firm. One question is: why do firms exist? Coase (1937) explained the existence of a firm as a way to minimize transactions costs associated with multiple individual contracts made through markets. He showed that when such contracting becomes sufficiently complex and costly, it becomes more profitable to internalize contracting expenditures through an organizational authority, that is, a firm.
A second question that these approaches to studying the firm address is: what is a firm? The vast literature relating to this question demon- strates that there is no clear or simple answer. The neoclassical view of the firm is that it is simply a production function, an engine of effi- ciency that responds to prices competitively set in its environment of input and output markets and, in some cases, by government regula- tions. The neoclassical model presents a passive view of the firm. The firm simply responds to variables that are exogenously determined, such as changes in demand or input supply characteristics that alter its revenues or costs and so alter its profit. The neoclassical firm is an out- put adjuster; market price changes as a result of firms’ output responses, including entry or exit in the long run. The neoclassical model of the firm is actually a theory of price rather than a model of firm behavior.
The neoclassical theory of the firm, therefore, is recognized as unsat- isfactory to explain certain observed complexities (Hart, 1988, 1990 and Demsetz, 1993). One alternative theory offered by Alchian and Demsetz (1972) as an explanation of the concept of a firm is that the firm is a monitoring device for production activities generated jointly by teams of individuals. The interactive nature of the activities required in production render it impossible to accurately measure the marginal productivity of any one individual worker. In their model, the entrepreneur-manager has the role of monitor who earns the residual from the team effort and is therefore motivated to monitor their activities to protect his or her residual rights. Along similar lines, Furubotn and Pejovich (1974a) model a firm where labor-owners hire the manager to monitor their own work as a way to minimize shirking by fellow laborers and there- fore protect their residual. The labor-owners are motivated to monitor the manager, for it is managerial effort that ensures them their residual rights. Cheung (1983) cites the example in pre-Communist China of a group of workers pulling a riverboat. He states: ‘The unique interest of this example is that the collaborators actually agreed to the hiring of a monitor to whip them. The point here is that even if every puller were perfectly “honest,” it would still be too costly to measure the effort each has contributed to the movement of the boat, but to choose a different measurement agreeable to all would be so difficult that the arbitration of an agent is essential’ (p. 8).
A different view of the firm as a nexus of contracts has been offered by Jensen and Meckling (1976) and Cheung (1983). This view follows from Coase’s definition of a firm as a contracting device that substitutes for multiple, more costly, market transactions. Jensen and Meckling propose the view of a firm as a set of contracts to avoid personalization of an organization which is a legal fiction. They assume that contracts are appropriately structured. They then examine how these contractual relationships affect the financial (equity-debt) ownership structure of the firm.
Cheung more fully develops the concept of a firm as a nexus of contracts. His idea is that firms develop in response to the costs of dis- covering and agreeing upon prices through markets, rather than in response to shirking. The nexus-of-contract theory of the firm explicitly considers the multiple contractual arrangements essential to the firm’s activities and financial structure rather than the firm as a simple meter- ing device. It thus avoids the problems associated with a monolithic view of the firm as a decision making entity, as in the neoclassical theory.
A third question in the theory of the firm extends Coase’s original question of firm definition by asking: what are the boundaries of a firm? Masten (1993) suggests, however, that if every economic relationship is regarded as a contract, then the nexus-of-contracts view of the firm is tautological. If the firm is a device for the purpose of minimizing transactions costs as Coase proposed, rather than simply a set of con- tracts, what can be predicted about its size and organization? This area of research largely focuses on the choice between institutional arrange- ments, that is, the choice between market and organization (firm). Joskow (1993) defines the relationship between transactions costs, firm boundaries, and firm governance in his comments on Williamson’s (1975) work: ‘Specific institutional arrangements emerge in response to various transactional considerations in order to minimize the total cost of making transactions. The boundary between a firm and a market provides a very rough distinction between the two primary institutional mechanisms for allocating many different organization structures … The specific set of institutional arrangements chosen would represent the governance structure that minimized the total cost of consummating the transaction of interest’ (p. 119).
The issue of boundary of the firm as a choice between institutional arrangements includes vertical integration, where the primary issue is the ‘make-or-buy decision’. Klein, Crawford and Alchian (1978), Williamson (1975, 1985), and Joskow (1985, 1993) emphasize the particular issue of minimizing transactions costs associated with asset and site specificity and certain contractual problems, such as the supplier hold-up problem. They consider the alternatives of vertical integration as a way to mini- mize these costs (the choice of firm, or ‘make’) and the use of long term contracts (the choice of market, or ‘buy’).
Hart (1990) and Holmstrom and Milgrom (1994) explain firm organ- ization as an institutional arrangement through property rights (asset ownership) as an alternative to transactions cost minimization. Hart’s theory focuses on property rights in physical assets. His theory proposes that property rights give incentives to owners to invest in the physical assets that identify the firm. He uses this theory as a rationale for the lim- its and direction of a vertical merger. Holmstrom and Milgrom (1994) consider employee incentives through their ownership of assets, much like independent contractors. The rights structure associated with this arrangement increases employee efficiency. I examine the role of prop- erty rights in managerial decision making later in this chapter.
Each of these various theories highlights a specific aspect of the analy- sis of the firm: why is production organized, how can the organization be classified in a meaningful way, and what are the limits of the organ- ization of production. Yet there remains to be generated a clear consen- sus on the origin or nature of the firm or on what directs decisions made in the firm. A connecting theme in these various analytical views of the firm is property rights theory.
Transactions cost analysis, contracts analysis, and principal–agent the- ories have been developed and have proceeded as separate theories with distinct applications to the theory of the firm. They are interrelated, however. Transactions costs are the costs of negotiating, monitoring, and enforcing contractual rights. Principal–agent relationships are contract based. The different objectives of the principal and agent generate trans- actions costs through the need to monitor and enforce the terms of the contract, that is, to enforce the legal and economic property rights of each party. It is the interest in these rights that generates the principal– agent behavior, the contracts to align their interests, and the associated transactions costs.
As I have noted, these alternative approaches are designed to address different questions within the theory of the firm. I would further argue that in each case the theory of the nature and boundary of the firm is not separable from a theory of managerial decision making.
To say that the theory of the firm is inseparable from a theory of managerial decision making is not to say that the manager is the firm. The firm is clearly a complex organization that involves multiple con- tractual as well as social relationships. The organizational aspects of the firm affect the conditions faced by the manager. Nonetheless, the manager is in a position of authority as well as leadership in the firm and thus affects the direction of the firm as organization. The manager is the decision maker who determines the allocation of resources within the firm and thereby affects the allocation of resources of the firm in the market. This sets the manager apart from the rest of the organization in the decision framework. It is this characteristic of managerial decision making that is my focus here.
Managerial decisions direct firm performance through choices in resource allocation, supplies and suppliers, and monitoring conditions, among other things. These decisions are tied to incentive structures that are derived from property rights.
In neoclassical theory the issue of managerial decision making never comes up, for in modeling the firm as a production function there is no distinction between manager and owner, or manager and firm. Such a distinction is irrelevant to the point of neoclassical theory, which is to predict the direction of resource flow in response to a change in a relative price. Neoclassical theory cannot nor was ever meant to address the questions raised earlier: why is production organized, how can the organization be classified in a meaningful way, and what are the limits of organization.
Outcomes of the neoclassical model serve as a benchmark of firm effi- ciency. This is possible through neoclassical theory because, by assump- tion, profit maximization is a feasible objective and property rights are clearly defined. There are no transactions costs, information problems, or agency problems. Of course, if any of these assumptions does not hold, then the predictions of neoclassical theory are called into question. The fact that many of these assumptions do not hold much of the time is precisely why alternative theories have been proposed and pursued.
Theories of the firm assume that managerial choices are based on a long run outlook. Neoclassical theory of the firm assumes long run profit maximization; managerial theories assume long run utility maxi- mization. Note, however, that the alternative approaches to the theory of the firm mentioned earlier are more in the spirit of neoclassical the- ory than in the spirit of managerial theories. Transactions cost theory focuses on organizational design in a way to minimize transactions costs so as to achieve efficiency and long run profit maximization for firm owners. With the nexus-of-contract theories and principal–agent theories, contract and organizational designs evolve to solve contractual problems such as monitoring requirements, asymmetric information, and the holdup problem. Ultimately, in each of these theories ineffi- ciencies are corrected by establishing an appropriate incentive system so that managerial decisions (alternatively considered firm decisions or organizational decisions) approach the optimal (that is, neoclassical) outcome. That is, the resulting organizational or contract design is one that achieves long run profit maximization. The organization or con- tract is an efficient production device, much like the depiction of the firm in neoclassical theory.
Managerial theories of the firm are built on the premise of separation of ownership of firm resources and control of those resources. In the theory of the firm, this premise of separation of ownership and control focuses on the implications of the corporate organizational structure. In the corporate structure shareholders have legal residual rights and managers have legal control rights. The basic line of argument of this issue is that managers through their legal control rights have effective economics rights to firm resources and are thus in a position to expro- priate at least some of shareholders’ legal residual rights.
The issue of separation of ownership and control has been the subject of some controversy. Economists on one side of the issue argue that while separation of ownership and control exist, it has no effect on resource allocation. Alchian (1987) defines ownership and control in terms of property rights. He defines control as the ‘exercise of rights to make decisions about uses of resources,’ and ownership as ‘bearing the consequent market or exchange values’ (p. 1032). The ineffectiveness of separation of ownership and control results from the ability of capi- tal markets to prevent managerial expropriation of shareholders’ own- ership rights (Alchian, 1969 and Fama and Jensen, 1983a). They reason that capital markets allow shareholders to respond to inappropriate control decisions (that is, management opportunistic behavior) by sell- ing their shares. The lower share value that results reflects negatively on management. The credible threat of action by shareholders is an effec- tive monitoring device. Property rights of shareholders are the key here.
The ability to transfer legal residual rights makes the threat of share- holders credible (Alchian, 1987).
The managerial market provides an additional albeit secondary source of discipline to mitigate the effects of separation of ownership and control. Managers have an incentive to maximize shareholder returns because doing so keeps their value high in the market for managerial services (Alchian, 1969). Managers and owners are aware, however, that replacement costs are positive. This can affect the credibility and will- ingness of shareholders or board members to threaten managerial replacement (Spencer, 1982). This reduces the effect of the managerial market as a monitoring device. As I show below the principal–agent problem also derives in a large part from the existence of asymmetric information which also alters the effectiveness of the capital and man- agerial markets as monitoring devices.
Economists on the other side of this controversy see the issue of separation of ownership and control as a significant principal–agent prob- lem. The problem primarily derives from the dispersion of ownership in a corporation across many shareholders (Williamson, 1963 and Milgrom and Roberts, 1990, 1992). Hart (1988) recognizes the principal–agent problem and suggests that the capital structure of the firm (that is, the equity-debt configuration) can act as a form of control mechanism. His analysis demonstrates that different capital structures affect the likeli- hood of potential takeover bids by superior management teams, putting less emphasis on the sale of stock by individual shareholders as a con- trol mechanism.
In general, the theory of the firm as organization has increasingly rec- ognized that the existence of capital markets has not eliminated the costs of monitoring corporate managerial behavior and that the issue of separation of ownership and control is a significant one. The expansion since 1980 of institutional investment in equity as well as debt securi- ties (for example, mutual funds) has further increased dispersion of ownership and distance between the shareholders (investors) and corporate managers, and gives further credence to this position (Samuelson, 2002).
Source: Carroll Kathleen A. (2004), Property Rights and Managerial Decisions in For-Profit, Nonprofit, and Public Organizations: Comparative Theory and Policy, Palgrave Macmillan; 2004th edition.